Warsh faces multiple alternative indicators of inflation as Fed sets new course

Federal Reserve Chairman Kevin Warsh said inflation is a “choice.” The same applies to how inflation is measured.

Central banks have their own favorite indicators, courtesy of the Commerce Department, but public databases are replete with other indicators of how best to view price pressures.

Many of them will be taking a hard look Wednesday as the Warsh Fed lays out plans on Wednesday for a “new direction” for how it will operate and, specifically, what data will trigger how it conducts monetary policy.

“My hope, my aspiration, is that nine to 12 months from now we will be able to use new technologies to simultaneously and in real time see what’s going on in the real economy and be able to make better decisions as central bankers,” he said during a debate at the European Central Bank Monetary Policy Forum in Sintra, Portugal.

Mr. Warsh has created five task forces to examine a range of Fed functions. One focuses on data and the other considers how authorities measure and react to inflation.

The review is sure to be about more than the age-old battle between headline and core inflation, with the latter excluding everyday necessities such as petrol and groceries due to their highly volatile prices.

Instead, the Fed could use this process as a way to incorporate other data points that paint a more complete picture of the cost-of-living challenges faced by consumers due to five years of high inflation.

variety of choices

These include measures from other central bank institutions, such as the Dallas Fed, and measures that focus on “trimmed average” inflation, which includes outliers. or the Atlanta Fed’s “sticky and flexible” inflation, which distinguishes between prices that tend to move up and down significantly and prices that are more stable. There are also widely tracked studies by the University of Michigan and the New York Fed, as well as private-sector measures such as the “Truflation” gauge, which employs “cutting-edge technology that provides the world’s only verifiable daily inflation index.”

Perhaps unsurprisingly, these measures can and do paint a very different picture of inflation, with some reinforcing the view that prices remain too high and others saying the Fed may be closer to its 2% target than its previous measures would suggest.

“A close reading of where inflation is heading is critical to determining whether the Fed needs to move interest rates,” Claudia Sahm, chief economist at New Century Advisors, said in a post on Substack on Tuesday. “However, trends are not destiny. Even a 2% trend does not guarantee price stability, as actual inflation can deviate from the trend, as it is now.”

A basic view of mainstream indicators is that inflation is well above the Fed’s 2% target.

According to the Consumer Price Index (a broad composite of what consumers pay for goods and services), headline inflation was running at an annual rate of 4.2% in May, with core inflation at 2.9%.

At the same time, the Personal Consumption Expenditures Price Index (the Fed’s preferred indicator that more aggressively adjusts to changes in consumer behavior, such as substituting expensive items for cheaper ones), put the numbers at 4.1% and 3.4%, respectively. Economists largely believe that core is a good long-term measure of inflation because it excludes the most volatile categories, especially given the impact of the Iran war on energy prices.

Nonstandard

However, other indicators show different results.

According to the Dallas Fed’s “trimmed average” of inflation rates, which excludes the 24% of items with the lowest price changes and 31% of the items with the highest price changes, the 12-month inflation rate is just 2.4%. However, there is one important caveat to what is considered a reliable indicator. Dallas Fed President Laurie Logan has warned that the methodology currently in place may be discarding incorrect prices.

Elsewhere, the Atlanta Fed’s flexible and sticky price indicators present an interesting dichotomy. This means flexible pricing is running at a 12-month annualized rate of 3.1%, with flexible pricing at 7%, the highest level since November 2022.

Truflation, on the other hand, paints a more benign picture at just 1.75%. This indicator has moved in roughly the same direction as the CPI and PCE indicators, but in June 2022 it showed a much higher peak of 11.5%, where the CPI plateaued at about 9%.

Finally, market-based indicators also indicate that the inflationary backdrop is less severe.

of 2 year government bond yieldThe market, sensitive to the vagaries of the Fed’s interest rate policy, soared after Mr. Warsh’s first news conference in June, but has since eased slightly. Similarly, the U.S. Treasury market’s five-year inflation measure has fallen sharply since May, now at just 2.26%, and the one-year “break-even” rate has fallen nearly half a percentage point since May, although it is still up about 3%.

For Warsh, all these data points, plus data from various agencies, form a complex mosaic that his task force must scrutinize. He said Wednesday that he believes the Fed’s standards will change dramatically to make them more responsive to the current environment.

“We no longer have to rely solely on data from government agencies that conduct surveys that are no longer relevant and have problems with measurement errors,” Warsh said. “If we do our job, we’ll be here in a year’s time saying we’ve discovered data that will help us make better decisions. We’re delivering on our promise.”